'Should I invest $150,000 in a vacation home?'

By Walter Updegrave, senior editor


(Money Magazine) -- My wife and I are 40 and currently have about $350,000 in savings, $250,000 of which is in an IRA. Would it be wise to invest $150,000 of the IRA money in a Jersey Shore rental property via a self-directed IRA? My wife says yes, but I'm not so positive. -- Bryan, Woodbury, New Jersey

Maybe your wife sees this as a chance to buy a beaten-down asset at a bargain price. And that it has the potential to add some zip to the returns on your retirement stash.

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Or perhaps she views an investment in a rental property as a way to diversify your portfolio.

Or, for all I know, maybe she's a fan of Snooki, Pauly D, and Mike "The Situation" and she'd like to have her own little piece of Jersey Shore action.

Whatever her reasons, I'm going to have to side with you on this one and recommend caution: I just don't think investing your IRA money in a vacation home (or any other real property, for that matter) is a very good idea at all.

Why?

Well, to start with, if you follow through on this plan, you would be putting a very large chunk of your IRA dough -- some 60% -- into an illiquid asset that requires a good deal of time and attention.

Not only that, but far from reducing risk in your IRA by diversifying, you're actually increasing it by concentrating so much of your money on just one property in one area. That's sort of like investing more than half of your IRA in a single stock.

I'd also note that while it's indeed possible to own real property by opening a self-directed IRA account, it's not exactly hassle free.

As I noted in an earlier column, there are a lot of nitpicky little rules and regulations governing IRAs that make it more difficult to do everything from getting financing for a property to maintaining it once you own it.

For example, IRS rules require that any money that goes toward the investment -- including everything from real estate taxes to insurance to upkeep and repairs -- come from the IRA itself.

You can't just throw in additional money out of your own pocket, except to the extent you may be eligible to make new IRA contributions of $5,000 a year, plus an extra $1,000 when you're 50 or older.

Put in more than that amount, and the IRS will consider it an excess contribution, which is subject to a 6% penalty each year it remains in the account.

Which means if the property itself isn't throwing off enough revenue to cover expenses -- or you don't have enough in your IRA or from additional contributions to your IRA to fund them -- you've got a problem.

You have a cushion of extra assets in your IRA that you could tap for additional cash. But selling those assets to pay expenses on the vacation home would mean even more concentration in that one property.

You should also be aware that the IRS is a stickler when it comes to what it calls "prohibited transactions" within an IRA. Among the prohibited transactions the IRS lists on page 44 of IRS Publication 590 is buying property for personal use in the present or in the future with IRA funds.

In other words, if your wife is thinking that your IRA money would be a good way to buy a second home that you could use for vacations -- or a house that you could rent now and later retire to -- she should know that's a no-no.

If the IRS catches you engaging in a prohibited transaction, your IRA could lose its IRA status, in which case you would likely be facing a big tax liability.

And by the way, if the real motivation behind this move is that you're figuring this may be a one-time chance to pick up beach-area property at depressed prices, you'll want to re-examine that assumption too.

While home prices in most areas of the country have indeed fallen substantially from their previous peaks, that doesn't necessarily mean they can't drop more. Indeed, some experts believe there's a significant chance that we'll see a double-dip in house prices.

For a look at the forecast for house prices in specific areas, you canclick here.

Bottom line: Given the hassles and the drawbacks, I seriously doubt it's worth it to buy real estate within an IRA, especially if it's going to mean devoting so much of your account to a single property.

Instead, I suggest you and your wife turn you efforts to making sure your IRA contains a truly diversified mix of stocks and bonds. If you're really convinced you also need real estate to have a well-balanced portfolio, then try one of the REIT (Real Estate Investment Trust) funds on our MONEY 70 list.

A REIT may not carry the same cachet as having property on the Jersey Shore. But you will get real estate exposure without the bother of owning bricks and mortar. To top of page

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